The Opposite Of A Value Trap

Grandmasters can “see” five or more moves ahead sometimes because they recognize a pattern. When they see a pattern they know what’s going to happen intuitively. There is no thinking involved. This is what Daniel Kahneman calls Thinking Fast and Slow.

Spier says you can do the same in investing. There is a clear pattern that good things tend to happen when you buy into irrational fear mixed with a lack of liquidity. One example is when Buffett bought Goldman Sachs in the middle of the financial crisis.

And, it’s just incredible because all mayhem was breaking loose and he dove straight into the middle of it and bought shares of Goldman Sachs. There was very little certainty about the way things were going to unfold. I think that was an example of him saying, “This is a valuable company. There is a lot of uncertainty around it but these guys are smart and will figure it out. And I’m buying into that uncertainty. And I’m buying into that fear.”

The opposite of buying fear is buying optimism. This pattern doesn’t tend to produce high returns. An example right now is Amazon.

The emotional pattern you need to get in to buy Amazon or Netflix right now is to say, “Yes, those guys are all exuberant about the future of this company but I’m even more exuberant.” And there’s no fear. You’re buying on top of other peoples’ exuberance and that’s a very, very different place to say, buying Goldman Sachs in the middle of the financial crisis.

Avoid Value Traps

A value trap is something that looks statistically cheap but is actually fairly priced or expensive. This can happen if a business is shrinking or cannot grow. Guy gives the example of an insurer – Replacement Lens Insurance – that is an incredibly profitable underwriter and trades at a low valuation. But the company had very little customer loyalty precisely because its premiums are so expensive. It also operates in a small niche which has limited market size. It will never grow and therefore isn’t cheap at all. Another example is your town’s local jewelry store. It has high margins but cannot meaningfully increase its volume over time.

The opposite of a value trap is a company which is not statistically cheap, operates in a large, growing market, and has high customer loyalty due to its low prices.

GEICO is a great example of this because GEICO can under-price its competitors while remaining profitable. Car insurance is a massive industry, and GEICO continues to attract new customers and keep them because of its low prices. Amazon and IKEA also follow this pattern.

How much is a company like this worth? They obviously deserve a premium valuation, but it’s difficult to pin-point how much.

Charlie Munger says that in investing it’s better to focus on avoiding stupidity than seeking brilliance. Warren Buffett says it’s better to buy a wonderful company for a fair price than a fair company for a wonderful price.

With this advice in mind it becomes clear:

Trying to figure out how much of a premium you can pay for Amazon and still make money is a case of seeking brilliance and should be avoided.

It’s best to own companies with a durable cost advantage operating in a large market because their customer base will grow over time.

These businesses are clearly worth more than the average business. If you pay only an average price for them, you are getting a good deal.

Questions or comments? Email matt@eaglepointcap.com

This is not a recommendation to buy or sell any stock mentioned. I do not have a position in any stock mentioned unless otherwise noted in this post. Do your own research: you are accountable for your own returns. Please read my full disclosure